Incentive

Financial system

Financial stability

Actuarial science

Statistics

Financial capital

Microeconomics

Economics

Business

Capital adequacy ratio

Mathematics

Risk-weighted asset

Capital requirement

Monetary economics

Operational risk

Econometrics

Leverage (statistics)

Risk management

Financial distress

Capital formation

Basel III

Finance

Profit (economics)

Journal of Financial Stability

This paper analyses the trade-off between additional loss-absorbing capacity and potentially higher bank risk-taking associated with the introduction of the Basel III Leverage Ratio. This is addressed in both a theoretical and empirical setting. Using a theoretical micro model, we show that a leverage ratio requirement can incentivise banks that are bound by it to increase their risk-taking. This increase in risk-taking however, should be outweighed by the benefits of higher capital, thereby leading to more stable banks. These theoretical predictions are tested and confirmed in an empirical analysis on a large sample of EU banks. Our baseline empirical model suggests that a leverage ratio requirement leads to a significant decline in the distress probability of highly leveraged banks.

The leverage ratio, risk-taking and bank stability